High equity markets despite geopolitical risks
Buttonwood presents other authors’ arguments on the impact of geopolitical risks on the financial markets and the economy as a whole. He underlines that geopolitical risks are disrupting trade and discouraging investment, however highlighting that this years’ geopolitical risks are not fundamentally different. Especially, he reminds that most equity markets are at high levels in spite of those risks.
Buttonwood in The Economist, Sept. 11th, 2014, “Geopolitical risk and markets: Wars and rumours of wars”
The western world is engaged in tit-for-tat sanctions with Russia; Islamic jihadists have taken over territory in Iraq and Syria; Israel recently engaged in the bombarment of Gaza, in response to Hamas missile attacks; Boko Haram are kidnapping children in Nigeria; China and Japan have been sabre-rattling over uninhabited islands. If you want to look for geopolitical risk, you can easily find it. Of course, it is worth pointing out that there has been no absence of alarming events in the last 25 years; two Gulf wars, a Balkan war and 9/11, for example.
Nevertheless, some find it striking that many equity markets are at, or near, all-time highs despite this diet of bad news. One should not overstate this bullishness; at the end of July, most major indices (including the Dow) were down on the year. Even now, Japan is still down and the UK and German market show gains of less than 2%. Perhaps markets would have been even higher but for the geopolitical factors.
There has been some good analysis of this elsewhere. In the FT, Gideon Rachman argued that investors' insouciance in the face of geopolitical risk might be down to their experience that change has been positive in the last 30 years; the fall of the Berlin Wall, the emergence of China as an economic power and so on. But now the re-emergence of nationalism whether in extreme (Russia/Ukraine), moderate (Japan/China tensions) or mild (Scotland) form points in the opposite direction. He observes that “Nationalism and international investment tend not to be comfortable bedfellows”.
Mouhammed Choukeir, the chief investment officer of Kleinwort Benson, has written that geopolitical risk has rarely affected markets over the medium to the long-term. The market even sailed through the Cuban missile crisis. He says that “Analysing 16 serious geopolitical crises since 1950, only four saw the S&P down one month later. Similarly, four events saw markets lower over the next six months or the next 12 months”.
As mentioned in yesterday's post, Deutsche Bank's epic long-term return study includes a section on the issue, entitled "the rise and fall of superpowers". It argues that “the main contender as a consistent major driver of significant structual change in global levels of geopolitical tension is the rise and fall of the world's leading power. In general we would argue that periods of single superpower world dominance have been times of relative structural geopolitical stability, whilst times of equal and competing great powers have been times of structurally high geopolitical instability”.
To illustrate this, they go all the way back to the turmoil that followed the death of Alexander the Great, although that seems a bit of a stretch; he only ruled for 13 years and spent much of the time fighting. He was a one-person source of geopolitical turmoil. The two more convincing examples are the Roman and British empires, aka the pax Romana and the pax Britannica. In each case, the empires peaked at more than 20% of global output; in each case, the dominant power had a strong incentive to encourage economic activity and had the military muscle (naval, in the case of Britain) to enforce its will.
All that ended in 1914, of course, after which America eventually assumed the superpower role, along with the high share of global GDP. But this is where the argument faces a bit of a struggle. The periods of pax Americana have been very limited. First, the threats from Germany and Japan had to be seen off. And then after 1945, the US faced a rival superpower in the Soviet Union which may not have matched it in economic power but did so in military might. So the shortish period of American hyperpowerdom can only be dated from 1990.
Certainly the 1990s were a period of prosperity and investor exuberance. But the perception of America's global dominance lured the Bush administration into the Iraq invasion of 2003, from which much subsequent instability has flowed. In any case, the US has now slipped below the 20% of global GDP ratio that marks global dominance. and its ability to leverage its economic power into political power has also waned. Deutsche cites three reasons : “First, since the global financial crisis the US (and the West in general) has lost confidence. The apparent failure of laissez faire economics combined with the US's weak economic recovery has left America less sure than it has been in a generation of its free market, democratic national model. As this uncertainty has grown, so America's willingness to argue that the rest of the world should follow its model has waned. Second the Afghanistan and in particular the Iraq war have left the US far less willing to intervene across the world. One of the major lessons that the US seems to have taken away is that it cannot solve all of the world's problems and in fact will often make them worse. Third, the rise of intractable partisan politics in the US has left the American people with ever less faith in their government”.
China has emerged as the rival superpower and is flexing its muscles in all sorts of ways. This leads Deutsche to conclude that “If this analysis is correct then the rise in the past five years, and most notably in the past year, of global geopolitical tensions may well prove not temporary but structural to the current world system and the world may continue to experience more frequent, longer lasting and more far reaching geopolitical stresses than it has in at least two decades. If this is indeed the case then markets might have to price in a higher degree of geopolitical risk in the years ahead”.
To this, I might throw in the internal tensions which have resulted from sluggish economic growth that have led to a rise in the vote of extreme parties, as mentioned in a previous post.
It has to be emphasised that all of these factors are long-term, rather than something that should trigger an immediate sell-off. My main conclusion is to be even more suspicious of those who argue that "this time is different" - that the first part of the 20th century when stockmarket valuations were lower is irrelevant because of two world wars. The current period is "normal" in that rival powers are competing for resources and influence; tension and thus conflict is inevitable. The Middle East may be going through a new Thirty Years war similar to that which plagued Germany in the 17th century. All this can and will disrupt trade and investment. Geopolitical risk is not going to go away.
